The purpose of an IRA, or a 401(k), is to fund your retirement and provide income when you are done working. 

While many retirees use their IRA for this exact purpose, others view it as a wealth transfer vehicle. Many people stuff a large portion of their savings into their IRA in anticipation of leaving it as an inheritance. 

If this is the purpose of your IRA, it might be time to reevaluate and find a better way to get your children the money you want to leave them.

Why you shouldn’t leave your IRA to your heirs

Like we mentioned, the purpose of an IRA is to provide retirement income. When you use it for estate planning purposes, it doesn’t work very favorably for your heirs. 

A traditional IRA or 401(k) is tax deferred, meaning you have to pay taxes on the money when you pull it out of the account since you did not pay tax on the money when you put it in. If you leave this account to your kids, they are going to have to pay this tax as well. 

If you leave your adult children your IRA, they have 2 options:

  1. Take the lump sum
    If left with an inherited IRA, most of the adult children we see take the lump sum. They have student loans, a mortgage, children, and they can use the money.

    Taking the lump sum also means paying the taxes in a lump sum. Say you’re leaving your child $300,000 and their work income is around $75,000. If they take the lump sum, their reported income for that year is going to be $375,000. In 2020, this would move them up 3 tax brackets from where they were.

    In one withdrawal, your children will have to pay a huge portion of your life savings to taxes.

  2. Spread out the payments
    Before the passing of the Secure Act, if your children inherited your IRA, they could choose to withdraw the funds by taking RMDs over their lifetime. This is referred to as a stretch IRA. This was a decent option. It provided your children lifetime payments and made the tax payments very manageable. 

    In 2019, Congress passed the Secure Act, which got rid of the ability to stretch inherited IRAs over beneficiaries lifetimes. This applies to anyone who inherits an IRA from a decedent who passed away after January 1, 2020 (Note: This does not apply to spouses.)

    Now, beneficiaries must deplete the inherited account over a 10 year period.

    What this means is not only will your children not be able to take lifetime payments, they will also have to pay higher taxes. Spreading out the payments over their lifetime allowed them to take smaller amounts, meaning their income was not increased significantly. Doing this over 10 years means larger distributions from the account, which increases their income by more, and in turn, also increases the taxes paid. 

A better ways to leave an inheritance to your adult children

If you know your plan is to leave the money in your IRA to your children, there are a few different strategies you can use to do this in a more tax efficient way. Not only can you leave the money to your heirs tax free, you can also get them the money quicker and without as many strings attached. 

Using Requirement Minimum Distributions to make life insurance payments

The first way to leave your children tax free money is through life insurance. Using money from your IRA, we can take distributions from the account, pay the taxes, and then funnel this money into a life insurance payment. 

At age 72, every IRA owner is required to take RMDs, or required minimum distributions. The government wants its tax money and this is when they make you start paying it. There are huge penalties for not taking your RMDs or not taking the right amount. 

We had a husband and wife who came to us with a fairly large IRA. On top of their IRA, they had Social Security benefits, a pension, and other savings. They never planned on needing the IRA for retirement income, they were just going to leave it to their children. 

They came to us when they had to start taking RMDs. They wanted to know the best place to put this money after they took it out of their IRA. We were able to find them a policy that left $1 million to their children after they both passed away. 

Their RMDs were about $40,000/year. They took them out, paid about $16,000 in taxes, and then used the remaining $24,000 to pay the premium for the policy. When they died, they were able to leave their kids even more than they initially planned. 

Roth IRA Conversion

If you do not want to go the life insurance route, another idea is to convert your IRA or 401(k) into a Roth IRA.  The defining characteristic of Roths is that the money put into them is already taxed. This means that when the money is withdrawn, it is tax free. 

Roth conversions are simply taking your IRA distributions, paying the taxes owed on the money, and then putting it into a Roth IRA. You will be able to pay the taxes while you are alive so that your children have to pay no taxes when you pass. 

There are no RMDs with Roth IRAs, so you will not have to worry about taking money out of the account once you reach 72. 

Your heirs will still have to drain this account within the 10 year period, but it will not have as large of consequences since they receive the money tax free. 

If the purpose of your IRA is not for retirement income, there is going to be a better place to put that money.  Cardinal can help you find the best place for your money as well as a strategy to get the inheritance you want to leave to your children, especially if you want them to get it quickly and easily.

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